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18. Cost-Based Valuation
Our third and final valuation method is often used when valuing physical assets. It tends to provide conservative valuations and is often used when a company is being liquidated.
Cost-based valuation methods
- Value is a function of the current cost to purchase or replace the asset
- Typically used to value physical assets (also know as tangible assets)
- When valuing companies, important to distinguish between going-concerns and liquidations
Tangible and intangible assets
- Tangible assets are physical assets within a business.
- Intangible assets are non-physical assets such as know-how, knowledge and reputation
- Intangible assets are often the most value in a company, because they are hard to replicate
Comparing the three valuation methods
- Cost-based methods tend to offer the most conversative valuations
- In bull-markets, market-based valuations are often the highest valuations
- In bear-markets, income-based valuations can provide the highest valuations
In this, the final lesson of our valuation course, we’re going to spend some time talking about cost based valuation.
For this valuation method, the value of an asset is a function of the current cost to purchase or replace the asset.
Cost based valuation is often used when valuing physical assets, such as fixtures and equipment, but can also be used when valuing companies.
When using this valuation method for companies, there’s one key question to ask yourself.
Is the company a going concern or being liquidated? If the company is a going concern, then you should value both the physical or tangible assets, such as fixtures, fittings, equipment and inventory, and the intangible assets.
These include reputation, name recognition and intellectual property, such as knowledge and know-how.
When a company is being liquidated, however, we only value the tangible assets.
Say for example we want to buy a sports bar that's for sale, and we're going to use the cost based valuation method.
The bar has some tangible assets, such as seats, tables, equipment such as beer taps and of course drinks, which we'll call inventory.
If this sports bar was going into liquidation, and no longer operating as a going concern, then only these tangible assets should be valued.
However, if we wanted to buy this sports bar, and it would continue in operation as before, then we'd need to include some intangible assets.
These intangible assets include its reputation in the local area where it’s been serving customers for over 20 years, and its strong reputation for hosting parties for the local college football team.
These assets are intangible and should be valued separately.
You might be slightly skeptical about the value of intangible assets from buying a company, but be sure not to under value these assets.
In many cases, they are the most valuable assets of a company, because they take time to build and are much harder for the competition to replicate.
Now let's take a closer look at liquidations where a company is shutting down and all of the tangible assets are being sold.
You may not have heard the phrase liquidation before, but you will be familiar with signs like this on the high street, which can offer excellent value.
Liquidations often happen over a very short time period, and as a result, the assets on sale are rarely exposed to very many buyers.
Consequently, great prices can be achieved in certain circumstances, but you need to be wary, particularly if the assets are second hand and require a lot of inspection.
When comparing the three approaches to valuation, cost based valuation tends to be the most conservative.
The positions of income based valuation and market based valuation can change depending on how the market currently views an asset.
In boom markets, when prices are rising and there’s optimism in the market, market based valuations tend to be higher.
In bear markets however, when prices are falling, income based valuation can offer higher valuations.
In our next valuation course, we'll build on the theory covered in this course and construct a detailed valuation model of a property investment from scratch, using both market based and income based valuation methods.